Underwriter

A company going public wants the issue to sell. The rules put a floor under that hope. A public issue must be subscribed to at least 90 per cent of the net offer to the public. Fall short of that and the company cannot keep any of the money. It has to refund the whole amount it collected.

So the company buys a safety net before it starts. It signs an underwriting agreement. Under that agreement, named institutions promise to subscribe to any shares the public leaves unsold. For giving the promise they are paid a commission.

An underwriter is the institution that makes that promise. It is not a buyer of first choice. It is the buyer of last resort, and it hopes never to be called on.

The workbook's glossary describes underwriting as an agreement, with or without conditions, to subscribe to a company's securities when its existing shareholders or the public do not subscribe to what was offered to them.

In India the same firms tend to do this work. Stock brokers and merchant bankers perform the function of underwriting.

The floor being protected. SEBI's regulations on public issues and the Companies Act require an issue to receive subscription of a minimum of 90 per cent of the net offer to the public. Failing that, the company has to refund the entire subscription amount received to the applicants not later than 4 days from the closure of the issue. For an issue that is underwritten, the workbook states the 90 per cent requirement including the subscription by the underwriters — which is the whole reason the agreement is worth paying for.

When it is compulsory and when it is not.

So in a book built issue the mandatory commitment bites only on the slice outside the QIB book — at most 25 per cent of the net offer, given the 75 per cent rule above.

When the agreement is signed. The workbook says companies enter into the underwriting agreement prior to filing the prospectus for the public offer of shares. Later in the same chapter it puts it more loosely, as an agreement entered into “at the time of a public offer of shares”. Two phrasings of one rule; learn the earlier, stricter one and know that the workbook says both.

Government securities have their own underwriters. Primary dealers are entities licensed by the RBI to act as underwriters for securities issued by the RBI on behalf of the government. They hold an agreement with the RBI that defines their underwriting obligations, and they receive an underwriting commission in return for the commitment. They subscribe to government securities in auctions announced by the RBI and resell them in the secondary market. Note the registration point in the same passage: all the other intermediaries listed there must be registered with SEBI, but primary dealers are authorised by the RBI.

What this paper does not give. XII says underwriters are paid a commission but gives no rate, no cap and no basis for it. It also does not split the commitment into hard and soft underwriting; that distinction is drawn by another NISM paper and is covered at hard underwriting. Do not answer an XII question from either.

Illustrative figures. Any commission rate below is an assumption used only to make the arithmetic run; this paper gives none.

A fixed price issue. Sagar Ceramics Ltd makes a net offer to the public of 1 crore shares at Rs 145, so Rs 145 crore. The 90 per cent floor is 90 lakh shares, or Rs 130.50 crore.

The issue closes with public subscription of 82 lakh shares = Rs 118.90 crore, which is 82 per cent. On its own the issue has failed.

Underwriting was discretionary here, because this was a fixed price issue. The right-hand column is what skipping it costs — and the cost is not the Rs 26.10 crore that went unsubscribed. It is the whole Rs 118.90 crore raise, plus everything the issue itself cost to run.

At an assumed 1 per cent commission on the Rs 145 crore underwritten, Sagar would have paid about Rs 1.45 crore for the net. The 1 per cent is mine, not the workbook's.

A book built issue, for contrast. Deccan Foods makes a net offer of Rs 400 crore through book building. Underwriting is mandatory, by the lead managers and syndicate members. But at least 75 per cent — Rs 300 crore — must be allotted to QIBs, and the QIB portion cannot be underwritten. So the mandatory commitment can attach to at most Rs 100 crore of that offer, not to Rs 400 crore. A candidate who works out the underwriters' exposure on the full Rs 400 crore has overstated it four times over.

Chapter 3 (Primary Markets). Underwriters turn up three times in it: in the early list of market intermediaries, where merchant bankers are noted as also acting as underwriters to the issue and primary dealers as the RBI-licensed underwriters of government securities; in the Underwriting block inside the issue process, which carries the 90 per cent floor, the 4-day refund, the fixed-price-versus-book-built rule and the QIB carve-out; and again in the later intermediaries section. The workbook's glossary at the end of the book defines Underwriting.

Nearly every examinable point sits in one paragraph. Expect: is underwriting compulsory (discretionary for a fixed price issue, mandatory for a book built one); what the minimum subscription is (90 per cent of the net offer to the public, counting the underwriters where the issue is underwritten); by when a failed issue must be refunded (not later than 4 days from closure); who may be appointed (SEBI-registered merchant bankers or stock brokers, and for a book built issue the lead managers and syndicate members); can the QIB portion be underwritten (no); and who underwrites government securities (primary dealers, licensed by the RBI).

• Discretionary for fixed price, mandatory for book built. The most examined line on this topic, and the one most often stated backwards.
• In a book built issue the underwriters are the lead managers and syndicate members. Not any institution the issuer picks — that freedom belongs to the fixed price route.
• The QIB portion cannot be underwritten, even though it is at least 75 per cent of the net offer. Mandatory underwriting therefore covers the smaller part of the issue, not the larger.
• 90 per cent is of the net offer to the public, not of the whole issue, and for an underwritten issue the underwriters' own subscription counts towards it. Both halves of that sentence get tested.
• The refund period is 4 days from the closure of the issue. The workbook says days, not working days. Do not add the word.
• Underwriter and merchant banker are different roles. A merchant banker may act as an underwriter, and in a book built issue a lead manager must; that does not make the two jobs one.
• Primary dealers underwrite for the RBI, not for SEBI. They are the one intermediary in this chapter's list that is authorised by the RBI rather than registered with SEBI.
• This paper gives no commission rate, and it does not use the hard-versus-soft underwriting split. Both belong elsewhere.
• Do not confuse the commitment with devolvement, which is the event of the unsold shares actually landing on the underwriter.